Paying a tax cost to switch funds - Realistic Settings

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monkeytoad
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Paying a tax cost to switch funds - Realistic Settings

Post by monkeytoad »

Hi Bogleheads,

The relevant wiki https://www.bogleheads.org/wiki/Paying_ ... itch_funds starts with the following:
Suppose that you have a fund in a taxable account, and you have an alternative fund with lower costs or lower taxes.
TBH, I've always been confused by this page when considering switching from a specific "fund" to an "alternative fund". Are these funds with identical performances? The ones of which I'm aware (e.g., VTI / ITOT, VXUS / IXUS) have identical costs also, and this probably has to be the case. Are these funds with dissimilar performance? If so, why would the logic not apply to nonsensical things, such as considering switching from bonds to stock ETFs (where the considerations clearly must take into account the estimated mean and variance).

I'd like to ask if the following calculations make sense. As an example, let's consider switching from MCHI https://www.ishares.com/us/products/239 ... -china-etf (Ishares MSCI China, which I unfortunately have due to a past horrible managed account at Merril) to VXUS. Let's say all gains are long term, and that taxation on both those as well as dividends is 25% (which is the case for me, but that's a separate story).

MCHI has a TER Of 0.59%, dividends of 3.26%, and over 5 years made -22.08%.
VXUS has a TER of 0.08%, dividends of 3.24%, and over 5 years made 18.61%.

1. One alternative is to just ignore the past value growth of each of the assets, but extrapolate the dividends. In this case, the dividend
is 3.26% * 0.75 for MCHI, vs. 3.24% * 0.75 = 0.73% for VXUS. For 5 years, the effective dividends are approximately 5 times that. This is additive - for each dollar, I need to count this as the excess net revenue.
2. Another alternative is to extrapolate the dividends and and value. In this case, the value of 1 dollar in MCHI 5 years from now is approximately 1 * (1 - 22.08 / 100) * (1 + 5 * 0.225 * 0.75 / 100) (using the approximation that (1 + \alpha)^n is about (1 + n \alpha)). This is because post taxation, the reinvestment of dividends increases the amount by a multiplicative factor of (1 + 0.225 * 0.75 / 100), but the growth of the value per year is around (1 - 22.08 / 5 / 100). Similarly, for VXUS, the value of 1 dollar in MCHI 5 years from now is approximately 1 * (1 + 18.61 / 100) * (1 + 5 * 3.24 * 0.75 / 100).
3. A more sophisticated alternative is to take into account the variance-covariance matrix between assets with some penalty, but I don't know what it should be, so I'm considering in the preceding only things roughly in the same "asset class", e.g., ex-US stock assets.

Regardless of the alternative chosen, the cost for switching out of MCHI is 0.25 times the capital gains in there. In both cases, I don't see where the TERs really come into play.

Do any of these two first alternatives make sense? Neither? Both? If both, how would you choose? Happy to learn from your views. Thank you very much.
Last edited by monkeytoad on Sat Jun 08, 2024 12:18 pm, edited 3 times in total.
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sycamore
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Re: Paying a tax cost to switch funds - Realistic Settings

Post by sycamore »

monkeytoad wrote: Sat Jun 08, 2024 7:21 am The relevant wiki https://www.bogleheads.org/wiki/Paying_ ... itch_funds starts with the following:
Suppose that you have a fund in a taxable account, and you have an alternative fund with lower costs or lower taxes.
TBH, I've always been confused by this page when considering switching from a specific "taxable account" to an "alternative fund". Are these funds with identical performances? ...
IMO the article is of general applicability. The alternative fund need not be identical or even roughly similar.

But the more similar the funds are (in terms of risk and expected return) means it's easier to be certain about the improvement from switching in order to gain lower cost or improved tax efficiency of the alternative fund.
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monkeytoad
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Re: Paying a tax cost to switch funds - Realistic Settings

Post by monkeytoad »

sycamore wrote: Sat Jun 08, 2024 8:06 am
IMO the article is of general applicability. The alternative fund need not be identical or even roughly similar.
Thanks, but I'm failing to understand. By this logic, I could deduce that, for a new investor, it pays to sell off VTI, and buy lottery tickets. Which step exactly is the logical fallacy in that?

If you want to limit this only to things defined as ETFs (which seems pretty arbitrary), this could conclusively shut down the "how much fraction to invest in ex-US?" debate, because the instant someone invests in VXUS (before capital gains), it seemingly pays to switch to VTI, which has a lower expense ratio, by this logic. So the answer would have to be 0, for those who don't yet own VXUS.
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FiveK
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Re: Paying a tax cost to switch funds - Realistic Settings

Post by FiveK »

monkeytoad wrote: Sat Jun 08, 2024 7:21 am Hi Bogleheads,

The relevant wiki https://www.bogleheads.org/wiki/Paying_ ... itch_funds starts with the following:
Suppose that you have a fund in a taxable account, and you have an alternative fund with lower costs or lower taxes.
TBH, I've always been confused by this page when considering switching from a specific "taxable account" to an "alternative fund".
It's a fund in a taxable account, not the whole taxable account.

It's also reasonable to assume that the comparison is between "similar" things: this is not a discussion about switching from 100% bonds to 100% stocks, etc.

Have you tried using the spreadsheet(s) suggested in the article?
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sycamore
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Re: Paying a tax cost to switch funds - Realistic Settings

Post by sycamore »

monkeytoad wrote: Sat Jun 08, 2024 8:16 am
sycamore wrote: Sat Jun 08, 2024 8:06 am
IMO the article is of general applicability. The alternative fund need not be identical or even roughly similar.
Thanks, but I'm failing to understand. By this logic, I could deduce that, for a new investor, it pays to sell off VTI, and buy lottery tickets. Which step exactly is the logical fallacy in that?

If you want to limit this only to things defined as ETFs (which seems pretty arbitrary), this could conclusively shut down the "how much fraction to invest in ex-US?" debate, because the instant someone invests in VXUS (before capital gains), it seemingly pays to switch to VTI, which has a lower expense ratio, by this logic. So the answer would have to be 0, for those who don't yet own VXUS.
Do whaaaat?!?

:)

The assumption of the article is that you own one fund but you'd rather own an alternative one for some (good) reason. That's the context of the article. A scenario of selling an investment and buying a lottery ticket is not something contemplated by the article and hopefully not by a reader of that article either!
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Re: Paying a tax cost to switch funds - Realistic Settings

Post by jeffyscott »

monkeytoad wrote: Sat Jun 08, 2024 7:21 am MCHI has a TER Of 0.59%, dividends of 3.26%, and over 5 years made -22.08%.
VXUS has a TER of 0.08%, dividends of 3.24%, and over 5 years made 18.61%.

1. One alternative is to just ignore the past value growth of each of the assets, but extrapolate the TER and dividends. In this case, the effective expense ratio is 0.59% - 3.26% * 0.25 = -0.225% for MCHI, vs. 0.08% - 3.24% * 0.25 = -0.73% for VXUS. Note that the effective expense ratios are negative, since, once they are purchased, they actually pay out net money...
The expense ratios are the expense ratios, the dividends do not change that. You are paying 0.59% per year vs. 0.08% per year. Over 10 years, the extra cost would be about 5%. If your tax rate is 25% on the capital gains, then it seems to me that you would about break-even in that time frame, if the gains are 20% of the balance in MCHI, since the tax would then be 5% of the balance. As the wiki points out, if you will eventually sell all you can do is defer the taxes. But it's also possible the asset would go to your heirs and get a stepped-up cost basis, avoiding taxes entirely.

Of course, we don't know whether China, or Ex-US, or maybe EM ex-China will prove to be a better investment. But looking at RA's expected returns*, they have China at 8.4%, Ex-US at 6.4%, and EM at 7% (real), using their valuation dependent model. And with their yield and growth model, China expected returns are actually less than EM (5.9% vs. 6.6%, with Dev ex-US at 5.5%).

Since actual returns are uncertain, China vs. EM is not enough of a difference under the valuation dependent model that I would pay 0.5% for a dedicated China fund (that ER difference reduces the expected return difference to less than 1%, plus a single country fund is riskier, and can't you get enough China in a diversified EM fund such as VWO :?: ).

If it's not worth the tax cost to make the change, then you can at least not reinvest dividends in MCHI and also maybe use a developed ex-US fund, rather than total international, depending on your desired weighting to EM. Of course, if there's ever an opportunity to sell some shares at a loss, you can do that.

* https://interactive.researchaffiliates. ... allocation
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monkeytoad
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Re: Paying a tax cost to switch funds - Realistic Settings

Post by monkeytoad »

Thank you very much for your answers! I do not really understand them ATM, so will think about them more. Appreciated!
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Re: Paying a tax cost to switch funds - Realistic Settings

Post by monkeytoad »

jeffyscott wrote: Sat Jun 08, 2024 8:50 am
The expense ratios are the expense ratios, the dividends do not change that.
You are definitely correct about this (obviously). I read about the calculation of dividends, and what I wrote in the original post was nonsensical, so updated it.
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Re: Paying a tax cost to switch funds - Realistic Settings

Post by jeffyscott »

In 1 and 2, are you essentially projecting future returns based on current dividend yield (and it's projected growth for 2)?

If so, rather than trying to do that myself if it were me, I would just look at RA's expected returns (as I did, above, for that aspect).

But in any case, if there's little reason to expect future China returns to exceed future diversified EM returns (and to do so by more than 0.5%, to offset the higher expenses), then the only real issue is the tax cost vs. the higher ER. I'm not sure if you're there yet or not. So I'll just ask: do you expect that the future total return of MCHI will exceed that of VWO/VEMAX?
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Re: Paying a tax cost to switch funds - Realistic Settings

Post by monkeytoad »

jeffyscott wrote: Sat Jun 08, 2024 12:27 pm In 1 and 2, are you essentially projecting future returns based on current dividend yield (and it's projected growth for 2)?

If so, rather than trying to do that myself if it were me, I would just look at RA's expected returns (as I did, above, for that aspect).
Thanks! Upon rereading your response and the article, it makes sense to me now.
Last edited by monkeytoad on Sat Jun 08, 2024 1:39 pm, edited 1 time in total.
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Re: Paying a tax cost to switch funds - Realistic Settings

Post by monkeytoad »

FiveK wrote: Sat Jun 08, 2024 8:34 am It's a fund in a taxable account, not the whole taxable account.
You're correct, thanks - that was some typo on my part. I updated the OP.
FiveK wrote: Sat Jun 08, 2024 8:34 am
It's also reasonable to assume that the comparison is between "similar" things: this is not a discussion about switching from 100% bonds to 100% stocks, etc.

Thanks! Upon rereading your response and the article, it makes sense to me now.
Last edited by monkeytoad on Sat Jun 08, 2024 1:40 pm, edited 1 time in total.
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Re: Paying a tax cost to switch funds - Realistic Settings

Post by monkeytoad »

sycamore wrote: Sat Jun 08, 2024 8:37 am A scenario of selling an investment and buying a lottery ticket is not something contemplated by the article and hopefully not by a reader of that article either!

Thanks! Upon rereading your response and the article, it makes sense to me now.
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Re: Paying a tax cost to switch funds - Realistic Settings

Post by BirdFood »

monkeytoad wrote: Sat Jun 08, 2024 8:16 am
sycamore wrote: Sat Jun 08, 2024 8:06 am
IMO the article is of general applicability. The alternative fund need not be identical or even roughly similar.
Thanks, but I'm failing to understand. By this logic, I could deduce that, for a new investor, it pays to sell off VTI, and buy lottery tickets. Which step exactly is the logical fallacy in that?

If you want to limit this only to things defined as ETFs (which seems pretty arbitrary), this could conclusively shut down the "how much fraction to invest in ex-US?" debate, because the instant someone invests in VXUS (before capital gains), it seemingly pays to switch to VTI, which has a lower expense ratio, by this logic. So the answer would have to be 0, for those who don't yet own VXUS.
Theoretical scenario, as I see it: You have a lot of money in a target date fund with an ER of .31, and you’d like to take it apart into a whole US stock market index fund with an ER of .02 and a bond index fund with an ER of .04. You’re doing this both to reduce the ER and for other well-thought-out reasons. There will be taxes on gains. You’d like to know how the ER savings compare to those taxes and in what range the win lies.
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Re: Paying a tax cost to switch funds - Realistic Settings

Post by monkeytoad »

BirdFood wrote: Sat Jun 08, 2024 1:44 pm
There will be taxes on gains...
Yes - thank you for your answer! Things make sense to me now.
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Re: Paying a tax cost to switch funds - Realistic Settings

Post by grabiner »

monkeytoad wrote: Sat Jun 08, 2024 7:21 am Hi Bogleheads,

The relevant wiki https://www.bogleheads.org/wiki/Paying_ ... itch_funds starts with the following:
Suppose that you have a fund in a taxable account, and you have an alternative fund with lower costs or lower taxes.
TBH, I've always been confused by this page when considering switching from a specific "fund" to an "alternative fund". Are these funds with identical performances? The ones of which I'm aware (e.g., VTI / ITOT, VXUS / IXUS) have identical costs also, and this probably has to be the case. Are these funds with dissimilar performance? If so, why would the logic not apply to nonsensical things, such as considering switching from bonds to stock ETFs (where the considerations clearly must take into account the estimated mean and variance).
The main situation in which the wiki article is relevant is for an investor who previously purchased a high-cost or tax-inefficient stock fund, and wants to switch to a low-cost tax-efficient fund. For example, a Vanguard investor might consider switching from the tax-inefficient Vanguard Equity-Income to Value Index, US Growth to Growth Index, or a combination of the two to 500 Index or Total Stock Market Index. If you have a fund that doesn't fit your investment needs, you should sell it even if the cost of selling exceeds the tax savings.
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Re: Paying a tax cost to switch funds - Realistic Settings

Post by monkeytoad »

grabiner wrote: Sat Jun 08, 2024 10:16 pm If you have a fund that doesn't fit your investment needs, you should sell it even if the cost of selling exceeds the tax savings.
Thanks! After rereading it more and correcting some of my mistakes, it made sense.
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Re: Paying a tax cost to switch funds - Realistic Settings

Post by placeholder »

Sometimes people have relics from active management like american funds products and might want to switch to similar index funds so it's a way to evaluate the cost in a taxable account which I faced some years back.
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Re: Paying a tax cost to switch funds - Realistic Settings

Post by monkeytoad »

placeholder wrote: Sun Jun 09, 2024 7:43 pm Sometimes people have relics from active management like american funds products and might want to switch to similar index funds so it's a way to evaluate the cost in a taxable account which I faced some years back.
You're right, thanks. It makes sense now.

(FWIW, the situation you describe (switching from active relics) is the impetus for my question.)
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Re: Paying a tax cost to switch funds - Realistic Settings

Post by grabiner »

monkeytoad wrote: Mon Jun 10, 2024 1:55 pm
placeholder wrote: Sun Jun 09, 2024 7:43 pm Sometimes people have relics from active management like american funds products and might want to switch to similar index funds so it's a way to evaluate the cost in a taxable account which I faced some years back.
You're right, thanks. It makes sense now.

(FWIW, the situation you describe (switching from active relics) is the impetus for my question.)
You may also want to switch from index to index. I once bought GWX, the first international small-cap ETF. Later, Vanguard introduced their own ETF VSS at a lower cost, so it was worth switching. (This happened to be near the 2009 market bottom, so I had a capital loss on my GWX sale and there was no cost to switch, but I would have done this even in a rising market.)
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